Bruce Norris is joined again this week by Matt MacFarland and Amanda Han with Keystone CPA. They are owners of Keystone CPA in Orange County, voted one of the top 100 CPA firms. Bruce has had the privilege of speaking with them in front of at least 4 or 5 audiences. Bruce has always learned something from them since they have an expertise in real estate and in their own business now for seven years. Bruce was pleased to speak with them since they saved him money and he has learned something from them every time he has heard them.
Bruce asked Matt and Amanda, who are married and started a family, if they get any tax breaks for having a kid. Although half-joking, Matt said you can and could claim them as a dependent. There are child tax credits that are available; and the more money you make the more they like to take these things away from you. You might as well hire your children to work in your business and give them money. The money you can pay them can be a tax deduction on your business. The other cool thing is when the kid is 8-10 years old, they can set up a ROTH IRA. Imagine what this could do for 60-70 years of tax returns.
In the last segment they ended with talking about contributing to retirement accounts. Bruce asked if you were going to contribute directly to a ROTH IRA, what would be the amount you could do. Bruce also asked what the rules are about converting your existing retirement account to a ROTH. Matt said you can contribute $5500 a year or $6500 if you are fifty or older. You have until April 15 of this year to contribute for last year. Typically you will not receive a deduction when you put the money into a ROTH since the benefit of the money going into the ROTH is that it is all tax-free. You are not going to double-dip, get a deduction on the front end and then tax regrowth on the back. It is a pretty powerful strategy just for the tax regrowth aspect of it. Amanda said for someone who has a 401k, as of a few years ago there is now a ROTH 401k component. This is great because within a 401k account, you can put up to $17,500 in the employee bucket. The rules are the same since this amount goes into the ROTH bucket and you do not receive a deduction.
Bruce said at one time they allowed you to convert your whole retirement account. If you had a good size IRA, you could say you want it to be a ROTH IRA and transfer $400 grand to it and take a one-time tax id. Bruce wondered if this was still available, to which Amanda said it is. It is one of those loopholes in how you receive a large amount of money into the ROTH IRA. Every year you are able to convert as much money as you wish from a traditional retirement account into a ROTH IRA. The downside, based on the date you are making that conversion, is the fair market value of that account becomes taxable income on your tax return for that year. Amanda said what she loves about the ROTH conversion concept is that the IRS actually gives you a risk-free trial.
If you were to say you had some money in your IRA and some great deals you want to put money into to get exponentially large returns, you could convert $100,000 into the ROTH account. By this time next year, if you look at the investment and notice you made a wrong investment decision, the value of that account has actually decreased and it is less than $100,000. They did not make the amount of money they wanted, but rather they lost money. What you can always do is before the return is filed you can always undo the ROTH conversion. It involves filing paperwork with the retirement custodian, and you retitle the asset back from the ROTH bucket into the traditional retirement bucket. You do not have to pay taxes on this money; it is as if it never happened.
Matt said it is worth point out that anybody can convert to a ROTH IRA now, regardless of their income levels. Before 2010 there was actually an income limit on who could actually convert to a ROTH IRA. There is still an income limit on who can contribute to a ROTH, but anybody can convert to one now regardless of their income levels. This opens up a lot more opportunities for people who maybe wanted to get more on their ROTH IRA but were not happy with the $5500 a year. There was an income limitation that you could not even do it without earning less than that.
A lot of people Bruce has as clients have a lot of rentals, so they are depreciating away. A lot of these people will be reselling properties at some point. Bruce asked if they flat out take a profit and do not do a 1031 exchange on a rental they have held for over two years, is there a recapture tax on the depreciation and is it taxed differently than capital gains. Matt said there is a recapture tax. The game that is associated with the depreciation you take will be taxed at 25%, slightly higher than long-term capital gains rates of 15% or 20% if you are in the higher income range. For any gain outside of the depreciation, you would only apply your regular capital gains rates of 15-20%. A chunk of it will likely be taxed at 25% for federal, while another chunk will be 15-20%. You will also have whatever your rate is for your state.
Bruce said some of the people in his business have offices at their home and are doing their deduction for having a home office. Bruce asked if they were to sell their residence and have that first $250,000; and if the first $250 is tax-free but he wrote off 20% of the residence for the last five years as office, would they have a recapture on it. Matt said it really depends on what you mean when you say “writing it off.” If you depreciate a portion of your house, when you go and sell it you will have to pay tax on that depreciation portion that cannot be excluded due to the $250,000 rule. Any deduction you took for a percentage of your mortgage interest, utilities, interest, association dues, repairs, or anything taken on a home office never gets recaptured. This will be a bigger chunk of what you took as a deduction anyway. There may be a little bit of depreciation recapture, but it is not significant.
Amanda has talked to a lot of investors, and they are very scared of the term “recapture.” A lot of times people forget that when we say “recapture,” it is called this because you have already gotten a tax deduction. When you say we have been depreciating for five years, it means we have gotten the money back from the IRS. Now all we are doing already is paying that back. There was still the value of money from the savings for the five-year period. Bruce asked about the rule that says you can make $250,000 or $500,000 on the sale of a residence. Bruce asked what the timeframe rules are on this and if it was two of the last five years you had to live in the property. Matt said he had used and owned a property for the last 2-5 years, but it does not have to be a consecutive two years. It has to pass of two of the five past year tests in order for you to be able to take advantage of that opportunity.
Bruce and Matt both know that whenever they have an audience, somebody sits in the back and thinks up every tricky question they can. They had one table where every tricky question came from the same table. Bruce laughed at this, and Matt thinks they were passing notes between each other. Now Bruce is in this seat. He asked about living in a property for two years and had not lived in it for almost three, then he sold the property after having lived in another residence for three years. He asked if the clock for his two years started clicking for the second place, or does he now have to stay there two years anew. Matt said in the first part of the example, he lived in the house for two years, moved out and lived somewhere for the next three and sold the former place. You can still claim the exclusion on this one even though you have not lived there for the past three years under this 2/5 test.
The clock starts when you move in, but one thing to keep in mind is you can only use the $250-$500 exclusion once every two years unless there are unforeseen circumstances that happen on your second house. This could include change of employment, moving, or a death in the family. In a general sense of the term, you get to use it once every two years. In those situations it is good for somebody to sit down with their advisor and plan strategically and proactively to see what will work best in their financial situation. Amanda can’t imagine this because she hates moving, but there are clients who have 3-4 kids, and what they do is move into a house, rehab it while living there with the kids, then move every few years to get the tax regain from the sale of the house. When you look at how much this could add up during four moves, it is a lot. It may be something inconvenient to make $2 million that is not taxable.
Bruce said the first time he heard this law, he actually called his late friend Robert Bruss. He was the smartest person and worked as an attorney and a lawyer. Originally when he read the law, Bruce did not think it could be true. He called Robert up and told him he must have misread it but told him what his conclusion was, to which Robert said he was exactly right. Bruce was shocked and did not understand how they got it passed. He asked himself how many states could you make $500 grand on a house. There are probably five states that benefited, yet it is a national law. Matt said we saw this a lot in the early 2000s when the real estate market was starting to take off. Amanda said we are seeing this more and clients are starting to take advantage of it. Depending on the market, more people may take advantage of it.
Bruce asked about somebody using a residence, and they are at a year and a half and have to do something to force move for a job. Bruce asked if they get 75% of the deduction, or does the IRS say they stayed there two years. Matt said the exclusion is based on the time you are there. You get 75% of $250, for example, or 75% of $500, and this would be your exclusion. There have been clients who saved money on this before. There may be some real estate agents who were in the business for 20+ years and are thinking of an old law. The law changed in 1997; and there was one client told to sell his place since he had been there a year and a half. He was told he had to pay taxes on it. They usually end up holding their property for more months get the two-year period, and it worked out for them.
In their situation they did not have a change as if they were moving, so it is important to know. They thought if they bought a more expensive house it would be tax-deferred. They thought they could buy another one at a little more expensive price and nobody would pay taxes. This was where the law changed a little. Bruce also asked about using a credit line on a residence where you have a house free and clear and want to get a $500,000 credit line. You then start using that to do investments. Bruce asked if the interest was all deductible on this, to which Matt said like a lot of things it really depends. Most of the time you will deduct that interest against your rental income, so in the sense that the interest is offsetting your rental income the answer is yes. There may be a way for you to deduct some of the interest against your primary residence as part of your itemized deduction. There is a lot of opportunity where you should be able to deduct a lot of the interest, it is just a matter of where and when. Bruce asked if there is a maximum amount as far as this goes for the IRS in regards to having a credit line or an amount more than what you paid for your property.
Matt said if you are going to do this, generally the amount of interest will be up to $100,000. For the interest on the first amount, you can just deduct against your W2. The interest on the other amount can be deducted against your rental income. The question is whether your rental properties end up with a non-profit or a loss. Amanda said there is no limit on how much interest expenses are deducted against rental income. The $100,000 limitation is only for key logs on primary homes.
One question Bruce always gets asked regarding flipped properties is how he saves taxes flipping properties. If he buys a house with the intent to resell it for a profit and hold it for 3-4 months, is there any magic to avoiding paying taxes on this. Amanda said there are a couple different things. One of the main things they typically look at with fix and flip clients is the entity structuring, and this is a strategy to help minimize self-employment taxes. Fixable income is considered ordinary income, so not only are we paying federal income taxes and state income taxes, but we also are paying upwards of 15% in self-employment tax. Typically they look at structuring a corporation where they can play between salaries taken from the owners versus distribution to the owners. This way they can try to minimize or cut the payroll taxes in half.
Another strategy that is reoccurring and they discussed earlier is with respect to retirement accounts. Since fixable income is active income, this opens up the door to set up different types of retirement accounts to reduce the taxable income on which we are paying taxes. Amanda said earlier that the simple IRA was still available to be set up for last year, but this was incorrect. The deadline for this has passed, but they can still set up a SEP IRA. If there are any fix and flippers who are looking at a large profit but did not do any planning for last year, it is still possible to set up a SEP IRA as one of the ways to reduce the taxes.
On the entity side, it depends on the person. However, if they did not already have an entity set up, then it is probably too late. Bruce asked how often the IRS looks at somebody’s buy and sell property that is not in an entity and say they have a dealer. Bruce asked if this designation happens to very many people. Amanda was not sure, but at least for her and Matt they have never had anyone be audited for that issue.
Bruce shared about the time that he was audited. Years ago when he used to do his own taxes, he was audited. He had done around 30-40 flips that years, filled out the proper paperwork, and the IRS guy thought he was a dealer since he did this so much. At first Bruce thought it was a complement until he learned that day you do not do an audit by yourself, or your taxes for that matter. How it came up was he had bought a condo for a very little bit of money. He sold it and carried a note. Because he was declared a dealer in that tax return, they went back and said that on that note it was considered that he had received all cash even though he had not received a dime. He had a taxable gain of $45 grand on a condo that cost him $15 and which he did not receive a dime down payment. It was a rude awakening for him.
Matt said 99.9% of the time they do not recommend that the clients represent themselves if they do get audited. The technical rule on the whole dealer versus non-dealer is a property-by-property designation. A lot of times they will say you are a dealer and will apply this general rule to every property sold, and that is not necessarily the case. A lot of times they will say in general that you are a dealer and are not going to apply this rule to every property you sold, but this is not necessarily the case. Someone may find themselves where the market is turning up, as we have seen in the last couple years. Maybe you happen to buy a property with the intention to hold it for a couple years, but you got an offer that you could not refuse and only held it for 8 months. This does not mean you were a dealer of that property, but if you are working for yourself then you know how to work around the intricacies of the law and find yourself in that bucket. It infects your other files, and you may not be knowledgeable enough to say it is not a dodd-to-dealer flip.
One other thing that happens to people in businesses is they repair properties. They bought it in 2013, and it needs a paint and carpet job as well as an air-conditioning unit and a roof. Bruce asked what part of this they can deduct fully as they repair it, and what items have to be more of a depreciated deduction. Matt said this is a good question and one where people want to sit down with their advisor and work ahead of time. This would be more of the gray area since the IRS would look at it, say you bought the property and that it will all be capitalized and depreciated over time. In reality, there are things you should be able to deduct right away if they are things you are fixing. However, it is really important on a buy side that you are documenting everything because they will try to say that everything should be capitalized.
If you are putting it in for the intention of getting it ready for rent. This is different from if you are holding the property for so many moves out and getting it rent-ready again. This is more of the repair angle that is tried and true. There is opportunity here, but it is a matter of planning ahead, sitting down, and going through your situation. You do not want to find yourself by default doing something one way when there is opportunity for others.
Bruce ends by discussing short sales. Bruce asked if the California debt in 2013 ever got resolved as far as receiving taxable debt forgiveness. Bruce asked if California and the IRS lined up for 2013, or is it still different. Matt said it is a little different. In 2013 the IRS still allowed homeowners to not pay any taxes on any cancellation of debt income up to about $2 million worth of debt. In California, this went away at the end of 2012; so there was one year where it was IRS only. Now in 2014 the opportunity for the IRS is no longer available. They may bring it back, but it remains to be seen. 2013 started out the same way, then they retroactively said they were going to be okay with it again. Matt said they extended it. Originally it was supposed to expire at the end of 2012, then they retroactively put it back in place for one more year.
Thank you for listening. For more information, you can contact them at 877-975-0975 or visit them on the website at www.keystonecpa.com.